I know it sounds crazy, but it’s true. Investors are paying the U.S. Treasury to hold their money in exchange for participation in expected rapid inflation.
Treasury Inflation Protected Securities, more commonly known as TIPS, are bonds backed by the U.S. government that protect against rapid inflation. TIPS pay interest like every other bond, except that the interest is tied to the consumer price index (CPI).
If inflation rises—as measured by the CPI—then the holders of TIPS get a fixed rate of interest plus the positive change in the CPI. If inflation falls—as measured by the CPI—then the holders of TIPS get a fixed rate minus the change in the falling CPI: an investor will lose money if inflation falls.
The U.S. Treasury recently sold 10-year TIPS for a record-low interest rate of negative 0.391% (source: Bloomberg, May 17, 2012). In essence, the buyer of this bond is paying the U.S. Treasury 0.391% to hold his or her money in exchange for a play on expected rapid inflation.
This is the third sale in a row where investors paid the U.S. Treasury to hold their money, but this last one hit the record.
Most interesting, these bonds were for a term of 10 years…not 10 months, which means that more and more investors are skeptical that the Federal Reserve can somehow manage to keep rapid inflation contained, which will eventually lead to a much higher CPI.
Even though gas prices have come down and commodities have sold off recently, the record-low interest rate environment and current easy-money policy may lead to a point where rapid inflation eventually rises higher and faster than the Federal Reserve can contain.
This isn’t criticizing the powers of the Federal Reserve; this is simply stating that history has shown that whenever world central banks wanted to control rapid inflation from getting out of control, they fumbled.
Of course, the record-low negative real interest rates of today also point to other stresses in the financial system aside from rapid inflation. The crisis in Europe, which I’ve been documenting in these pages, continues to deteriorate fast. To protect themselves from a possible new financial crisis, eurozone investors are buying treasuries and TIPS in order to protect their money.
But the reason to buy TIPS instead of just U.S. Treasuries cannot be explained by the European crisis alone and the fear of rapid inflation. Most of Europe is in a recession and the U.S. seems stuck at two percent gross domestic product (GDP); unable to gain economic traction. And China is showing signs that the economy there is possibly contracting (more on that below, in “Michael’s Personal Notes”).
If investors believe that the global economy is about to enter a recession, then the central banks around the world will continue to print money, which will eventually lead to rapid inflation, which is why the demand for TIPS is so strong.
Negative interest rates on TIPS is a signal to me that investors are so concerned with the current economic environment that they are willing to pay the U.S. Treasury in order to hold their money. Not a good sign.
The Chinese economy appears to be falling apart, fast…
While GDP growth figures released by the People’s Bank of China about the Chinese economy are indicating a slowdown, there are other indicators that are flashing bright red contraction signals.
When the Chinese economy was expanding at a stronger clip last year, year-over-year growth in electricity consumption ranged in the 10% to 11% range, with one month registering a 16% increase (source: Forbes, May 13, 2012). Electricity consumption is a very accurate reading of growth, because it shows how much more the Chinese economy is working to produce goods.
When the Chinese economy being slowed down in the last quarter of 2011, electricity consumption growth slowed to the six percent to eight percent range, year-over-year, and this persisted into 2012.
What is most disturbing now is that, for March, electricity consumption grew just 0.7%!
Couple this with the fact that rail cargo volumes in the Chinese economy are growing at half the rate they were last year, while sales of bulldozers are off over 50% in March when compared to last year, and it gets even more disturbing.
There are other figures released by the People’s Bank of China that point to an alarming slowdown. Loan growth is critical to any economy, because it measures how much new investment and consumption is being generated. In April 2012, the People’s Bank of China reported that loan growth fell 8.2% from last year. Can you say “contraction?”
In April, exports were expected to rise 8.5%, because, despite Europe being in a recession, the reliable U.S. of A was going to come through and buy Chinese goods to support the Chinese economy. Exports actually rose only 4.9%.
Imports were supposed to jump by 11%, because this time is similar to North America where producers prepare goods in October and November for the Christmas holidays. However, imports barely showed a pulse, up just 0.3% during their preparation for their holiday season…not a promising sign.
These statistics have not gone unnoticed by the People’s Bank of China and the leaders in China, who are clearly worried about the direction of the Chinese economy. The reserve requirement ratio—which is equivalent to lowering interest rates—was lowered for the third time since November last week.
Furthermore, just this week, the premier of China provided fast-track approval for infrastructure spending in the Chinese economy. Growth was the theme, as projects scheduled for the end of the year were moved up to right now (source: Reuters, May 22, 2012). Smells like desperation, as the leaders realize that the Chinese economy is slowing much faster than anyone thought.
If most of Europe is in a recession and China is slowing down and now showing signs of contracting, who is going to jumpstart global growth? The U.S. economy is barely hanging on and showing signs of fatigue.
If the Chinese economy continues to contract like it did n March and April of this year, this will have serious consequences for the North American economy.
Where the Market Stands; Where it’s Headed:
I received an e-mail alert from CNN Breaking News on Friday that said that last week was the worst week for major U.S. stock indices this year. The Globe & Mail (May 21, 2012) ran a story saying that Friday marked the end of the worst 13-session period for the Dow Jones Industrial Average since October 1974.
Reading these reports, I think to myself: this is nothing. Europe is in recession, China’s growth has slowed considerably, and the U.S. is not far from falling back into recession. The worst is yet to come.
The end of the bear market rally that started in March of 2009 will not be a straight line down. The market will bounce back whenever it gets oversold (we saw that yesterday). The Fed will have to finally come to the table with QE3; the government will need to borrow even more money to get the economy going.
But, in the end, the natural forces of the secular bull market will prevail. It’s just a matter of time.
What He Said:
“You’ve been reading my articles over the past few months and have seen how negative I’ve become on the U.S. economy. Particularly, I believe it’s the ramifications of the faltering housing sector that are being underestimated by economists. A recession doesn’t take much to happen. It’s disappointing more hasn’t been written on the popular financial sites and in the newspapers about the real threat of a recession happening in 2007. I want my readers to be fully aware of my economic opinion: I wouldn’t be surprised to see the U.S. economy in a recession sometime in 2007. In fact, I expect it.” Michael Lombardi in PROFIT CONFIDENTIAL, November 13, 2006. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.